Question

Ziege Systems is considering the following independent projects for the coming year:

Project	Required Investment	Rate of Return	Risk
A	$4 million	12.25%	High
B	5 million	14.75	High
C	3 million	10.25	Low
D	2 million	9.75	Average
E	6 million	13.25	High
F	5 million	13.25	Average
G	6 million	7.75	Low
H	3 million	12.00	Low

Ziege's WACC is 10.75%, but it adjusts for risk by adding 2% to the WACC for high-risk projects and subtracting 2% for low-risk projects.

1. Which projects should Ziege accept if it faces no capital constraints?

   Project A	-Select-AcceptRejectItem 1
   Project B	-Select-AcceptRejectItem 2
   Project C	-Select-AcceptRejectItem 3
   Project D	-Select-AcceptRejectItem 4
   Project E	-Select-AcceptRejectItem 5
   Project F	-Select-AcceptRejectItem 6
   Project G	-Select-AcceptRejectItem 7
   Project H	-Select-AcceptRejectItem 8

2. If Ziege can only invest a total of $13 million, which projects should it accept?

   Project A	-Select-AcceptRejectItem 9
   Project B	-Select-AcceptRejectItem 10
   Project C	-Select-AcceptRejectItem 11
   Project D	-Select-AcceptRejectItem 12
   Project E	-Select-AcceptRejectItem 13
   Project F	-Select-AcceptRejectItem 14
   Project G	-Select-AcceptRejectItem 15
   Project H	-Select-AcceptRejectItem 16

   If Ziege can only invest a total of $13 million, what would be the dollar size of its capital budget? Enter your answer in millions. For example, an answer of $10,550,000 should be entered as 10.55. Round your answer to two decimal places.

   $    million

3. Suppose Ziege can raise additional funds beyond the $13 million, but each new increment (or partial increment) of $5 million of new capital will cause the WACC to increase by 1%. Assuming that Ziege uses the same method of risk adjustment, which projects should it now accept?

   Project A	-Select-AcceptRejectItem 18
   Project B	-Select-AcceptRejectItem 19
   Project C	-Select-AcceptRejectItem 20
   Project D	-Select-AcceptRejectItem 21
   Project E	-Select-AcceptRejectItem 22
   Project F	-Select-AcceptRejectItem 23
   Project G	-Select-AcceptRejectItem 24
   Project H	-Select-AcceptRejectItem 25

   What would be the dollar size of its capital budget? Enter your answer in millions. For example, an answer of $10,550,000 should be entered as 10.55. Round your answer to two decimal places.

   $    million

Answer 1

a) For high risk projects, WACC = 10.75% + 2% = 12.75%

  For average risk projects, WACC = 10.75%

For low risk projects, WACC = 10.75% - 2% = 8.75%

WACC (Weighted average cost of capital) is the weighted average cost that is expected to be incurred when a firm raises its capital for a project. For a project to be selected, its expected rate of return should be higher than the cost of capital (adjusted with risk).

For high risk projects

Project B and E should be accepted, since expected rate of return is higher than WACC.

Project A should be rejected, since expected rate of return is lower than WACC.

For average risk projects

Project F should be accepted, since expected rate of return is higher than WACC.

Project D should be rejected, since expected rate of return is lower than WACC.

For low risk projects

Project C and H should be accepted, since expected rate of return is higher than WACC.

Project G should be rejected, since expected rate of return is lower than WACC.

b) As Ziege can invest a total of $ 13 million, all the projects cannot be selected. Therefore projects which have the highest excess over the relative WACC should be given priority.

Projects	Cost ($) In millions	Rate of Return (%)	Relative WACC (%)	Excess (Return – WACC)
B	5	14.75	12.75	2
C	3	10.25	8.75	1.5
E	6	13.25	12.75	0.5
F	5	13.25	10.75	2.5
H	3	12	8.75	3.25

The projects with high the excess, from highest to lowest are H, F and B.

Projects	Costs ($) in millions
H	3
F	5
B	5
TOTAL	13

Thus we can accept projects H, F and B with a total of $ 13 million budget.

c) Now it’s been said, Ziege can raise additional fund even beyond $13 million, but with an expense of additional 1% in WACC for every additional $5 million ( or partial increment) of new capital.

Looking at excess over WACC computation in point (b) above, we can see that since the excess (Return – WACC) in project E is of only 0.5% and if additional cost of 1% is added in WACC then the rate of return of Project E will be less than the WACC. Therefore project E is also rejected in this case.

Thus, we are left with projects H, F, B and C.

Projects	Costs ($) in millions
H	3
F	5
B	5
C	3
TOTAL	16

Now, the projects accepted are H, F, B and C . With a total dollar size of $16 million capital budget.